A: If fundamentals remain favorable, current valuations are not an impediment to the market moving higher over the remainder of the year. In fact, continued slow, but positive, economic growth; low inflation; and reasonable valuations should be enough to produce respectable returns for equities in 2013. That said we would expect more volatility in Q2 as the economy struggles with the cumulative impact of the tax hikes and sequester.
Q: What to worry about now?
A: There are obviously an unlimited number of issues that could derail the US market, but I would worry about two in particular: Europe and a movement away from the United States’ current “Goldilocks” economic environment. On the former, so far investors have taken last week’s chaotic Italian elections in stride. Should that change, and should Italian bond yields start rising back above 6%, I would expect another bout of risk aversion.
The second risk is closer to home. The US market has benefited from an economy that is healing but not healing fast enough to endanger the Fed’s asset purchase program. If we see either fiscal drag-induced economic weakening or evidence that the economy can stand on its own two feet – meaning the Fed could take its foot off the accelerator – I would expect some pullback in stocks.
Q: What to consider buying now?
A: While US stocks overall still look reasonably priced and cheap relative to bonds, some US sectors look expensive. In particular, I would be cautious on US consumer stocks – both consumer staples and consumer discretionary stocks – and US small caps, which all look extremely priced relative to fundamentals. At the same time, US energy, technology and mega cap stocks look like bargains now. These sectors are accessible through iShares Dow Jones U.S. Energy Sector Index Fund (NYSEArca: IYE), iShares Dow Jones U.S. Technology Sector Index Fund (NYSEArca: IYW) and the iShares S&P 100 Index Fund (NYSEArca: OEF).
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.